By: Vern Krishna, CM, QC – Counsel, Tax Chambers LLP (Toronto)
One of the early considerations in setting up a business is the appropriate structure to maximize its rate of return, tax benefits, and minimize shareholder risk. To be sure, the simplest, and cheapest, solution is to directly hold one’s shareholding in the operating business. This has the advantage of simplicity, but may not always be the most efficient structure. In appropriate circumstances, there are alternative structures that can be more beneficial, albeit more expensive, to set up and manage shareholdings. Ultimately, we must balance various considerations, and choose the structure that suits the circumstances.
A holding company (Holdco) allows shareholders to structure their business affairs with greater flexibility than they would have if they were all shareholders in a single operating company (Opco). Similarly, where there are two or more shareholders of an Opco, a holding company can make it easier to time the payment of dividends to suit the individual circumstances of each shareholder participant. This is particularly the case if the shareholders have unequal shareholdings, have differing personal and financial circumstances and financial profiles. We can also have multiple holding companies to satisfy different shareholder interests.
Liability Protection
The first advantage of a holding company is that it can add a layer of personal shareholder protection from liability for damage caused by the operating company. In most cases, shareholders of the holding company are protected from claims against their personal assets for damages caused by the underlying operating company (OPCO). The creditors of OPCO will be restricted to the assets of the operating company. There are, however, some exceptions for shareholders of corporations that are tax debtors to the CRA.
Shareholder Liability
A special rule applies to shareholders who receive dividends from companies with which they do not deal at arm’s length. Section 160 can render an individual who receives property, whether directly or indirectly, in a non-arm’s length transaction, jointly and severally liable for the transferor’s outstanding taxes as at the date of the transfer. Subsection 160(1) is as follows:
“Where a person has, on or after May 1, 1951, transferred property, either directly or indirectly, by means of a trust or by any other means whatever, to
(a) the person’s spouse or common-law partner or a person who has since become the person’s spouse or common-law partner,
(b) a person who was under 18 years of age, or
(c) a person with whom the person was not dealing at arm’s length, the following rules apply:
(d) the transferee and transferor are jointly and severally liable to pay a part of the transferor’s tax under this Part for each taxation year equal to the amount by which the tax for the year is greater than it would have been if it were not for the operation of sections 74.1 to 75.1 of this Act and section 74 of the Income Tax Act, … in respect of any income from, or gain from the disposition of, the property so transferred or property substituted therefor, and
(e) the transferee and transferor are jointly and severally liable to pay under this Act an amount equal to the lesser of
(i) the amount, if any, by which the fair market value of the property at the time it was transferred exceeds the fair market value at that time of the consideration given for the property, and
(ii) the total of all amounts each of which is an amount that the transferor is liable to pay under this Act in or in respect of the taxation year in which the property was transferred or any preceding taxation year, but nothing in this subsection shall be deemed to limit the liability of the transferor under any other provision of this Act.”
Thus, there are four essential conditions for the subsection to apply:
1. there is a transfer of property;
2. at the time of the transfer, the transferee is the transferor’s spouse, common-law partner, a person under 18 years of age, or a person with whom the transferor was not dealing at arm’s length;
3. the transferor is liable to pay tax at the time that the property is transferred; and
4. the fair market value of the property transferred exceeds the fair market value of the consideration that the transferee gives to the transferor.
Anti-Avoidance
Section 160 is an anti-avoidance provision that is intended to prevent taxpayers from divesting assets into friendly hands in order to escape their outstanding taxes.[i] Although the rule works reasonably well when the CRA uses it to attack delinquent taxpayers who are attempting to circumvent their outstanding tax liabilities, it can have unexpected consequences for those who do not fully understand its reach.
Strict Liability
Section 160 is a strict liability provision that does not require any intention on the part of the transferor to avoid taxes.[ii] There is no due diligence defense.[iii] There are four essential elements of the rule:
- there must be a transfer of property;
- the transferor and the transferee must be at non-arm’s length (or related) with each other;
- the transferor must owe taxes at the time of the transfer; and
- there must be a shortfall of consideration, in that the fair market value of the property transferred must exceed any amount that the transferee pays.
Meaning of Transfer
“Transfer” is broadly interpreted to include virtually any kind of transaction that involves the passage of property, including gifts, from a person to another. It is immaterial that the parties are acting in good faith at the time that the property is transferred. For example, contributions to a spousal registered retirement savings plan while the transferor owes tax renders the transferee liable, even after the parties divorce.
“Transfer” includes any divestiture of property from one person to another and includes gifts. In Fasken Estate, for example, the courts said:[iv]
“the word ‘transfer’ is not a form of art and has not a technical meaning. It is not necessary to a transfer of property from a husband to his wife that it should be made in any particular form or that it should be made directly. All that is required is that the husband should so deal with the property as to divest himself of it and vest it in his wife, that is to say, pass the property from himself to her. The means by which he accomplishes this result, whether direct or circuitous, may properly be called a transfer.”
Non-Arm’s Length
Shareholders in closely-held family corporations, either alone or in conjunction with other family members, usually control the corporation. Hence, they do not usually deal with the corporation at arm’s length.
No limitation period
The shareholder’s liability for taxes unpaid at the time that the property is transferred may result from a reassessment of the corporation many years later. Because there is no limitation period under section 160 in respect of the liability, the shareholder remains on the hook indefinitely. Indeed, the shareholder remains liable even after the corporation has been sold or become insolvent.
For example, assume that a corporation declared a $2 million gain as a capital gain in 2000. In 2001, when the corporation is fully paid up on its taxes, it pays a dividend of $100,000 to a passive shareholder who is “related” to the controlling shareholder. Five years later, the CRA reassesses the corporation and characterizes the gain as business income. Assume that the incremental tax is $200,000. The corporation disputes the reassessment loses the appeal in 2020, by which time it is bankrupt. In these circumstances, the passive shareholder is personally liable for the corporation’s unpaid taxes, if he or she did not provide fair market value exchange for the dividend in 2011.
The Reach of Section 160
The combination of the broad interpretation of “transfer”, the absence of any due diligence defence, and the unlimited time during which the Minister can assess the recipient for the transferor’s tax makes for a powerful anti-avoidance weapon, which the CRA wields, regardless of the bona fides of the parties.
Dividends
Dividends on shares represent the yield or income return on invested capital. Corporations may pay dividends in cash, property, or stock to their shareholders. Thus, the essential question is: Do shareholders give fair market consideration in exchange for dividends that they receive?
In corporate law, directors declare dividends at their discretion. The dividends represent the investment yield on shareholder capital. Subsection 24(3) of the Canada Business Corporations Act (CBCA)[v] provides as follows:
“Where a corporation has only one class of shares, the rights of the holders thereof are equal in all respects and include the rights
(a) to vote at any meeting of shareholders of the corporation;
(b) to receive any dividend declared by the corporation; and
(c) to receive the remaining property of the corporation on dissolution.”
Shareholders do not work for their dividends in the conventional sense of providing labour or services. The mere investment of their risk capital is sufficient to warrant a return if, as, and when the directors exercise their discretion to pay dividends on the capital stock. In contrast, services are compensated through salary, bonuses, or stock options, which are treated differently for tax purposes.[vi]
A shareholder purchases his or her shares for fair market value consideration in exchange for the rights that attach to the shares. Subsection 25(3) of the CBCA provides:
“A share shall not be issued until the consideration for the share is fully paid in money or in property or past services that are not less in value than the fair equivalent of the money that the corporation would have received if the share had been issued for money.”
Further, a corporation may not add to a stated capital account in respect of any share that it issues an amount greater than the amount of the consideration it receives for the share.
One of these rights is the right to receive the income of the corporation by way of periodic cash distributions in the future or, eventually, through a liquidating distribution. Although the directors of a corporation may not be under any immediate legal obligation to distribute cash dividends in any particular year, they are always under a fiduciary obligation to the corporation. The right of shareholders to ultimately participate in the profits of the corporation is the raison d’être of their risk investment in the corporation.
Thus, generally speaking, a shareholder’s initial investment in the shares of the corporation can be said to be the consideration that he or she pays for present rights (the right to vote), future rights (the right to a distribution of income as dividends), and distributions of capital on winding-up. The cost of the shares when issued should be equal to their net present value at the time that they are issued by the corporation. A corporation cannot issue shares for inadequate consideration. The rights, including the right to future dividends, attached to shares are not gifts. The payment for the shares is their net present value, as determined at the time of the exchange.
In Neuman v. Minister of National Revenue, [1998] 1 S.C.R. 770 (S.C.C.), at page 791, the Supreme Court of Canada, referring with approval to the dissenting reasons of LaForest J. in McClurg v. Minister of National Revenue, [1990] 3 S.C.R. 1020 (S.C.C.)), confirmed that no consideration can be given for the payment of a dividend:
“… a dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder.”
In Algoa Trust, the corporation paid cash dividends to its shareholders in 1982. The corporation had satisfied all of its income tax assessments for its 1975 to 1981 taxation years at the time that it paid the dividends. Some time later, however, Revenue Canada issued reassessments in respect of the corporation’s 1979, 1980 and 1981 taxation years. When the corporation failed to pay its tax, the Minister sought to recover its tax liability from its shareholders on the basis that the corporation and its shareholders were jointly and severally liable for the tax under Section 160.
The tax court determined that shareholders do not provide any consideration for their dividends:[vii]
“A shareholder receives a dividend solely because the right to a dividend is an attribute of owning shares. Directors of a corporation are normally under no obligation to declare dividends and a corporation is under no obligation to pay dividends on its shares … notwithstanding that generally an investor expects, or hopes, to receive dividends on the shares he purchases.”
The Federal Court of Appeal approved Algoa Trust in Addison & Leyen Ltd. v. Canada, [2006] F.C.J. No. 489 (F.C.A.), as the leading authority for the proposition that section 160 may apply to a dividend. Thus, shareholders who are at non-arm’s length with their corporation are within the scope of Section 160 for tax purposes.
However, in Davis [94 DTC 1934], the Tax Court held that dividends could be paid in exchange for services rendered, or to be rendered, which could count as consideration. The taxpayers’ accountant testified that there were tax advantages [lower rates] in compensating the shareholders for their work by paying dividends instead of salary, and that it was the custom of his office to declare the dividend at the beginning of the fiscal year, in anticipation of the services that the shareholders would render later in the year. Relying on dicta in McClurg v. Minister of National Revenue, [1990] 3 S.C.R. 1020, [1991] 1 C.T.C. 169, the court accepted Mrs. Davis’ testimony that she gave adequate consideration in services in exchange for the dividend. The court considered the services to be legitimate quid pro quo. Therefore, there was no shortfall of consideration, and section 160 did not apply.
Davis extended the principles of corporate law in holding that a corporation may pay dividends to non-arm’s length shareholders as legitimate quid pro quo. Dividends paid to passive shareholders who do not provide quid pro quo of services, or other contributions, remain at risk for unpaid corporate taxes if the corporation is unable to meet its obligations to the fisc.
Fair Market Value of Dividends
The leading case on the definition of “fair market value” is the Federal Court judgment in Henderson v. Minister of National Revenue (1973), 73 D.T.C. 5471 (Fed. T.D.), at page 5476[viii]:
“… the highest price an asset might reasonably be expected to bring if sold by the owner in the normal method applicable to the asset in question in the ordinary course of business in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell. I would add that the foregoing understanding as I have expressed it in a general way includes what I conceive to be the essential element which is an open and unrestricted market in which the price is hammered out between willing and informed buyers and sellers on the anvil of supply and demand.”
The fair market value of property is determined in the hands of the transferor and is the same in the hands of the transferee.[ix]
CONCLUSION
The purpose of section 160 is to prevent taxpayers from rendering themselves judgment-proof by transferring their property to, inter alia, persons with whom they do not deal at arm’s length. Its reach, however, is much longer, and can catch innocent shareholders who receive dividends from closely held corporations. Legal counsel will want to ensure that their opinions on the propriety, and effect, of corporate dividends appropriately accounts for the extended reach of the provision.
Vern Krishna, CM, QC, FRSC is Tax Counsel, TaxChambers, LLP (Toronto) and Professor of Common Law at the University of Ottawa. He is a member of the Order of Canada, Queen’s Counsel, a Fellow of the Royal Society of Canada, and a Fellow of the Chartered Professional Accountants of Canada. His practice encompasses tax litigation and dispute resolution, international tax, wealth management, and tax planning. He acts as counsel in income tax matters, representing corporate and individual clients in disputes with Canada Revenue Agency.
[i] Medland v. R., [1999] 4 C.T.C. 293 (FCA.). See also: Algoa Trust v. R., (sub nom. Algoa Trust v. Canada) [1993] 1 C.T.C. 2294, 93 D.T.C. 405 (T.C.C.); Charrier v. Minister of National Revenue (1988), 89 D.T.C. 108 (Eng.), [1989] 1 C.T.C. 2214, (sub nom. Charrier c. M.R.N.) 89 D.T.C. 104 (Fr.) (T.C.C.); Fasken Estate v. Minister of National Revenue, (sub nom. Fasken v. Minister of National Revenue) [1948] Ex. C.R. 580, 49 D.T.C. 491, [1948] C.T.C. 265, [1949] 1 D.L.R. 810 (Can. Ex. Ct.); Jones v. Skinner (1835), 5 L.J. Ch. 87 (Eng. Ch.); Kieboom v. Minister of National Revenue, [1992] 2 C.T.C. 59, 46 E.T.R. 229, (sub nom. R. v. Kieboom) 92 D.T.C. 6382, (sub nom. Canada v. Kieboom) [1992] 3 F.C. 488, (sub nom. Minister of National Revenue v. Kieboom) 145 N.R. 360, (sub nom. Minister of National Revenue v. Kieboom) 57 F.T.R. 11 (note) (Fed. C.A.).
[ii] Livingston and Montreuil v The Queen,[1996] 1 C.T.C. 2182 (TCC)).
[iii] In Algoa Trust v. Canada, [1993] 1 C.T.C. 2294, 93 D.T.C. 405 (T.C.C.), Rip, J.T.C.C., said at page 2302 (D.T.C. 411):
“The purpose of section 160 is to foil an attempt by a taxpayer who is liable to pay any amount under the Act to avoid the fisc by transferring property otherwise available to satisfy the liability to one of three groups of persons, including a person with whom he or she was not dealing at arm’s length.”
[iv] Fasken Estate v. M.N.R., [1948] C.T.C. 265 at 279, 49 D.T.C. 491 at 497 (Ex. Ct.); see also St. Aubyn v. A.G., [1952] A.C. 15 at 53 (H.L.), per Lord Radcliffe:
If the word “transfer” is taken in its primary sense, a person makes a transfer of property to another person if he does the act or executes the instrument which divests him of the property and at the same time vests it in that other person.
[v] Canada Business Corporations Act, RSC 1985, c C-4.
[vi] Neuman v. MNR [1998] 3 CTC 177 (SCC)
[vii]At p. 411.
[viii] Affirmed by the Federal Court of Appeal in [1975] F.C.J. No. 613 (Fed. C.A.)).
